Max Tax

There are but two certainties in this life: death and taxes. Neither are particularly attractive prospects, but the fact is they are both inevitable. In regard to tax, we must at least acknowledge it as a necessary evil. It provides the money Governments need to pay for essential services such as schools, hospitals, roads and a host of other things that are absolutely essential for a healthy and functional society.

Of course the Government doesn’t always spend the money wisely, and the specifics of the tax system are far from perfect, but we must nonetheless acknowledge that as Australians we enjoy a reasonably fair system. The amount of tax we pay is directly proportional to our earnings; the more we earn, the more we are taxed. Nevertheless, the majority of us loathe tax and will often feel as though we are being treated unfairly.

Figure 1. Relationship between income and tax. Calculated according to 2008-2009 tax scales.

Ask yourself this question: would you prefer to pay $10,000 or $1,000,000 in tax this financial year? Naturally, the lower amount seems more attractive at first glance, but I would definitely prefer to have the higher tax liability. After all, if your tax bill was $10,000 it means that you would have earned around $53,000 in taxable income last year. On the other hand, if you are paying a million dollars in tax you must have generated around $2.3 million in income. So in essence, the more tax we pay the more privileged we are.

We can however seek to generate income in a more tax effective manner, and in this regard it’s hard to find a more tax effective income than dividends. Thanks to the imputation system, franked dividends come attached with tax credits that account for the tax already levied. With the corporate tax rate at 30%, that means that you essentially only pay the difference between that and your own personal income tax rate. What’s more, you receive the full tax rebate even if your shares are held under a Self Managed Super Fund (SMSF), which means that in most cases you will actually pay no tax on your dividends, and indeed can even receive a tax refund.

Margin loans also offer a great tax advantage in the sense that interest payable is tax deductible. That is, interest is paid with pre-tax income. Investors can also elect to pre-pay interest, and if this is done prior to the end of the financial year, it can be claimed as a deduction for the 2008-2009 period. Furthermore, although shares are used to secure the loan, investors are still entitled to the full value of all franking credits received.

There is also the potential for you to take advantage of a negative gearing strategy (which tends to be popular amongst property investors). If the value of your dividends is less than the interest charged, you will pay no tax on your dividends at all, and as a bonus you are still able to use your franking credits to offset other sources of income.

Consider the example of an investor who has a $100,000 portfolio, with a $50,000 margin loan (that is, they are 50% geared). Assuming the portfolio produces a total dividend yield of 3.5%, and interest is charged at 7%, then the $3500 earned in dividends is completely offset by the interest deduction (in effect the dividends are completely tax free. Alternatively, you could view this as having an interest free loan). If the dividends are fully franked, the investor will also be able to claim around $1500 worth of imputation credits which, for those earning between $80,000 - $180,000, equates to a tax rebate of $900.

Had the investor decided instead to just invest the $50,000 of their own capital, they would have received $1750 in dividends and $750 in imputation credits. For those on the marginal rate of 40% (anyone earning between $80,000 - $180,000), that means a tax charge of $250, and an after tax dividend of $1,500. Although the net income position is greater than it was under the geared scenario, we must remember that the investor in the first example had exposure to $100,000 worth of shares, and hence is set to generate a capital gain that is twice as big. When a gain is eventually crystallized it too will be subject to tax, however if the shares are held for longer than 12 months tax is levied on only HALF the gain. Regardless of your marginal tax rate, that’s a substantial discount.

The bottom line is that investors should do everything they can to minimize their tax, and the share market is the most tax effective asset class available. However, despite the tax advantages, success in the market will nevertheless eventually attract some tax in most situations, but this is something we can’t really complain about. Ultimately it comes down to a choice between losing money and paying no tax, or making money and paying some tax. I certainly don’t like paying tax, but I know what I would prefer.